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Brexit, the pound, and the J-curve effect

How should we assess the effects to date of the UK’s vote to leave the European Union (Brexit) back in June? In the months since then, we have been inundated with a raft of conflicting evidence about its short term impact on the economy. For example, see here for some recent negative developments. Figures for overall growth, industrial and manufacturing performance, the stock market etc have been seized upon variously by ‘Leavers’ and ‘Remainers’ as proof of their sometimes apocalyptic warnings prior to the vote.

One should never pay too much attention to monthly or even quarterly figures on the economy, which tend to be revised over time as more reliable data becomes available. For now, the consensus seems to be that there has been no immediate negative ‘shock’ to the economy, but there is still vigorous debate about the longer term consequences of leaving the EU.

One clear economic change, which happened the moment the results of the Brexit vote became clear, was the sharp fall in the pound against the currencies of its trading partners, including the US dollar and the euro. Since the summer, its value appeared to have stabilised and even recovered some ground on the back of some positive economic news. But following the Conservative party conference last week, in which the Prime Minister appeared to be leading the country towards a ‘hard’ Brexit, with a full withdrawal from the EU’s single market in order to be able to control immigration, the currency has once more come under pressure.

I have argued before that a lower value for the pound could actually be a good thing for the UK’s economy as a whole. We have been running a large current account deficit of up to 7% of GDP at the end of 2015, the highest level since records began. A lower value for the pound should make our exports more competitive and our imports more expensive. This has the potential to boost exports and reduce imports, leading to an improvement in the balance of trade and the current account. This rebalancing is long overdue, but it is not guaranteed. The effect of a devaluation on the trade balance depends on the responsiveness of trade volumes to the price changes of tradeable goods and services.

For a devaluation to have a positive effect on the trade balance, the percentage increase in the quantity of exports sold abroad needs to be greater than the percentage fall in their price, and the percentage fall in the quantity of imports bought should be greater than the percentage rise in their price. These measures of responsiveness are known in economics as price elasticities. In the theory, the price elasticities of demand for exports and imports should sum to greater than one for an improvement in the trade balance to occur. This is called the Marshall-Lerner condition.

Even if the current account improves in the long run with the new lower level of the pound, as long as the latter is sustained, there may be a deterioration in the short run. In this case, a devaluation can lead to a fall in export revenue and a rise in spending on imports. This is because the price changes of goods traded internationally can take some time to change consumer behaviour, so that lower export prices only lead to higher volumes sold after a lag, and vice versa for imports. This is known as the J-curve effect, since a graph of the effect of a devaluation on the trade balance can show an initial deterioration followed by an improvement in the longer term, taking the shape of a ‘J’ (see diagram below).

If the J-curve effect is in operation for the UK, it may still be some time until the current account improves substantially and in a sustained manner. So the jury is still out on one of the effects of the Brexit vote, as long as falls in the pound do not become excessive and uncontrolled, potentially leading to a crisis. And of course, Brexit itself hasn’t even happened yet. It will be many years before studies of the long term impact are able to be conducted. The renegotiation of trade deals, for example, can take a long time, leading to uncertainty among businesses.

An improved current account, should that be one of the outcomes of the Brexit vote, is essential to a rebalancing of the UK economy in the longer run and an improved economic performance. Those who argue for the benefits of lower private and public sector borrowing, and falling private and public debt to GDP ratios, should welcome policies, inadvertent or not, which shrink the UK’s current account and move it towards balance, something which has been too long in coming.

3 thoughts on “Brexit, the pound, and the J-curve effect”

Please excuse me when I am not directly relating to your instructive reasoning in the above post. However, the fragments of my thoughts may help put matters into perspective.

The other day, I was approached by a German head-hunter who asked me to help organise an event focussing on the effects of Brexit, particularly on the labour markets at Luxembourg and Frankfurt. He envisioned mass immigration by bankers from London to these two places. I cautioned. I lived through a number of ‘revolutions’ (beginning with the Big Bang in the City of London), things tend to work out more subtly.

For instance, in the past Continental Europe used to be rather anti-banking in its legislative ambitions, only held back by the UK. It may well turn out that, owing to the unleashing of hitherto restrained political forces, after Brexit London is going to become an even more attractive place for the financial world. More likely, there will be mixed and balancing responses on both sides of the new Brexit divide.

On the most general level, let me say this:

The UK will still be the UK, a long time after the EU has gone. Whatever negative repercussions the Brexit may burden the UK with, they will be small compared to the negative effects that the EU is having on the largest part of its members; the problems created by the EU for EU members are more substantial and significant than the difficulties a country like the UK may be facing that now has gained greater policy flexibility by vindicating its sovereignty. Apart from the systematic economic disaster that the Maastricht-EU is, the European hyper-state is the worst onslaught against living democracy in Europe since Adolf Hitler.

I do not understand how the Left could fail to recognise that the EU is the perfect mechanism for corporate interests to prevail over labour. (I suspect, though, the Left is no longer the Left, but rather an extension of the pie-in-the-sky green movement, thoroughly detached from the concrete interests of the working population.)

At any rate, what I told my EU-happy head-hunter friend (who likes to chime in with the Brexit-bashing voices that now have become UK-bashing voices) is that he might be better advised to prepare for the crash of the EU than to spend his energy on heckling “the stupid, egotistical Brits.”

Being an admirer of the level-headed tone of this blog, I ask you to bear with the polemical slant of my comment.

No worries, thanks for your thoughts. I think the left/post-Keynesians and Marxists are quite anti-EU and the euro as it restrains the potential for full employment fiscal and monetary policies and (for the latter) nationalist industrial policies. So the left is surely divided, but here in the UK, many on the centre left came round to the EU, imagining that the social chapter would enhance workers rights following the deregulatory policies of the Thatcher/Major governments. Given the poor overall performance of the eurozone, and the disastrous response to the eurozone crisis, maybe the left will be persuaded otherwise now, or maybe they think that a reformed EU would be better. There is definitely a left case for Brexit, and those who favour more state intervention at the national level rather than the supranational level (as a way of managing globalisation) should surely support it.

Personally I have mixed feelings about Brexit. The campaign was ugly and stoked anti-immigrant feeling beyond what was justified. Both sides overplayed their hands by making exaggerated predictions about staying/leaving the EU, and many of these key political players are now nowhere to be seen, with a new Prime Minister and cabinet in place. It has made for an interesting and rather dramatic few months, with surely more to come.

About Me

I have an MSc in development economics from SOAS, University of London and, while I now work for a charity, I remain passionately interested in the subject and how it can be used to promote sustainable human progress.
Apart from economics, I enjoy reading, walking, Qi Gong exercise, classical music, following professional tennis and athletics and spending time with friends and family. I also take an interest in politics, usually focussing on policy rather than personality, so that I don’t get too fed up with it.